Two-time finalist for Gerald Loeb Award - this year for Forbes magazine work and in 2010 for online commentary and blogging. I am a C.P.A. and freelance journalist with credits in the Financial Times, Boston Review, American Banker, Columbia Journalism Review, Accountancy Age, Accountancy Magazine, Forbes, and others. I also blog at my own site, re: The Auditors, a specialized news site about the business of the Big 4 audit firms. I have been quoted in the New York Times, Wall Street Journal, Chicago Tribune, Crain's Chicago Business, Chicago Magazine, Chicago Sun-Times, Financial Times, Reuters, Forbes, Harvard Business Review, BusinessWeek, American Lawyer, California Lawyer, American Banker, Columbia Journalism Review, The Times of London, The Guardian, the Financial Chronicle (India) and others. To reach me email fmckenna2010@gmail.com.

The PCAOB inspection team found serious auditing deficiencies in all 23 audits they reviewed. The PCAOB released the report on August 18, the first anniversary of the SEC’s approval of temporary rules that gave the regulator the authority, under the Dodd-Frank Reform Act, to require registration and, therefore, inspection of the auditors of broker-dealer firms, a majority of which do not audit any other SEC registered companies.

This was the first time most of these firms were scrutinized by anyone but their peers in the accounting industry.

Auditors of broker-dealers have special responsibilities, including reporting to the SEC on material inadequacies found during their audits and insuring compliance with net capital and customer funds segregation rules. The firms and the audits inspected by the PCAOB fell far short of meeting these requirements.

In 13 of the 23 audits, inspectors found that firms “did not perform sufficient procedures to identify, assess, and respond to the risks of material misstatement of the financial statements due to fraud.”

In ten of the 23 audits, inspectors found that firms “did not perform sufficient procedures to identify the existence of related parties and material related party transactions, or in instances where evidence of related parties existed, did not perform sufficient procedures regarding material related party transactions.”

In 15 of the 23 audits, the firms “did not perform sufficient procedures to test the occurrence, accuracy, and completeness of revenue.”

In 12 of the 23 audits, the firms “did not perform sufficient procedures to place reliance on records and reports of the broker or dealer or reports from service organizations that were used in audit procedures.”

In six of the nine audits where securities valuation was included in the inspection, the firms “did not perform sufficient procedures to test the valuation of securities.”

In four of the 23 audits, the firms “did not sufficiently evaluate identified control deficiencies to assess the risk of material misstatement or did not evaluate identified errors to determine whether a control deficiency existed.”

In seven of the 23 audits, the firms “did not perform sufficient audit procedures to test the accuracy and completeness of certain financial statement disclosures.”

These firms were not judged by any new rules. The auditors operate, for now, under generally accepted auditing standards (“GAAS”) issued by the American Institute of Certified Public Accountants (“AICPA”).

The PCAOB also said one firm failed to maintain its independence in accordance with SEC rules in two audits. SEC rules on auditor independence apply to auditors of brokers-dealers, not the AICPA rules that are more lenient regarding prohibited services.

“In each case, the failure resulted from the firm preparing, or assisting in the preparation of, the financial statements that were being audited.”

I told you in July about the problems with independence in the smaller audit firms.

One issue that provoked heated discussion at the Chicago forum was auditor independence. It seems many of these Certified Public Accountants and broker-dealer auditors were under the mistaken impression that it’s the AICPA’s rules for auditor independence that apply to them, not the SEC’s. SEC rules, post-Sarbanes-Oxley Act of 2002, prohibit an auditor of an SEC-registered firm from performing a list of nine prohibited services including bookkeeping and systems design and implementation for its audit clients.

Several audit firm professionals tried to convince the SEC and PCAOB staff that they were mistaken in the belief that broker-dealer auditors could not sign the broker-dealer audit opinion as well as help implement accounting software, prepare period-end journal entries and compile those same financial statements and regulatory reports that they would audit. PCAOB staff told me that this issue has come up at every forum.

Those audit firm professionals were dead wrong.

The PCAOB issued its report on the “interim inspection program” incredibly quickly, less than six months after conducting the inspections. In contrast, the inspection of a public company audit firm covers the previous year’s audits and the final report is typically not issued until the following year.

When things go really bad for audit firms at the PCAOB, the Sarbanes-Oxley rules give them several ways to fight the outcome and delay the publication of the criticisms. Deloitte had until May 19, 2009 to show a good faith effort to address concerns and fix the defects cited in the nonpublic portion of the final report for audits performed in 2006. The PCAOB could not issue the private portion of the Deloitte inspection from 2007, covering 2006 audits – the part that addressed concerns about audit quality and firm management – until October of 2011.

The PCAOB has complained in the past about both the secrecy they are forced to work under per Sarbanes-Oxley and the delays built into the inspection and reporting process that allow audit firms to litigate the release of any negative results until they are completely neutralized by the passage of time.

In spite of the quick turnaround on this broker-dealer inspection report, getting to this point was like traveling on a slow boat to China. I described the roundabout way we ended up with at least some scrutiny of broker-dealer auditors in this column in July.

Section 17(e) of the Securities Exchange Act of 1934 (as amended by the Sarbanes-Oxley Act of 2002) requires every registered broker or dealer to annually file certain financial statements with the SEC that are certified by an audit firm that is also registered with the PCAOB.

The SEC allowed an exemption to the PCAOB registration requirement for auditors of registered broker-dealers until the Madoff fraud occurred. At that point, the exemption was allowed to expire.

As of fiscal years ending after December 31, 2008 the financial statements of non-public broker-dealers must be certified by a PCAOB-registered public accounting firm. Dodd-Frank officially extended the PCAOB’s authority to allow oversight of auditors of broker-dealers.

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